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Monday, May 14, 2012

Efficacy of FVE Model in Relative Value Trading

- Fair Volatility Estimate (FVE) Model is calculated from SPY ETF (underlying) prices while VIX is calculated from S&P500 Index options' (derivative) prices.

- FVE calculates the "Fair Value" of VIX.

- Now, if the above statement holds true, then one should be able to trade VIX relative to FVE--that is buy when VIX is below FVE (because it is assumed to be undervalued) and sell when VIX is above FVE (because it is assumed to be overvalued).  Now let's assume that even if the FVE model could calculate the "Fair Value" of VIX, the "Fair Value" is not a static number.  In strong rising or falling trends, which often materializes in the VIX, what may seem undervalued/overvalued today, may not be so tomorrow...

- Nevertheless, the graph shows a simulation of an $100k account following the Relative Value Trading Strategy utilizing VIX front month futures prices and FVE Indicator modified for VIX front month futures prices.  I call it FVEF indicator.  The trading rules are crude and simple, and I am using the rules only to illustrate the efficacy of FVE Model.  On daily closing prices, Buy VIX futures when its price is 5% or more below FVEF.  Sell VIX futures when its price is 2% above or more than FVEF.  Stay long or short until next reverse trade signal.  Slippage of 0.075 was assumed with $2.50 commission / futures contract.  Finally, in the simulation profits were reinvested but no leverage utilized.

- Yes, that is log scale and compounded annualized return >180%.  Now I'm not claiming such return is likely moving forward, and the drawdowns are significant.  But I've run this simulation back in September of 2011 (not posted) and it still seems to be "working".  Yes, the -5% & 2% values are optimized values but this simulation result is not a result of "curve fitting".

- The biggest risk to the efficacy of FVE Model is the marginal breakdown of the KEY assumption--that underlying market leads the derivative market most of the time.  I believe this was not necessarily the case prior to 2008 market meltdown when options were being utilized en masse by the discretionary investing public, resulting in what I believe was a "tail wagging the dog" situation.  After 2008 market meltdown, I believe on the margin, discretionary options trading has decreased significantly, replaced by HFT and algorithms.  As long as this environment continues, I would believe that the FVE Model would remain effective.

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